Liquid Alternatives Haven’t Lived Up to the Hype (Yet)

4 charts that show how liquid alternatives have disappointed so far

Aug 02, 2018

Jason Kephart, Morningstar Research
Services LLC

If you split your portfolio evenly between stocks and bonds, half
the time you’ll probably think you have too little risk and half the
time you’ll feel like you have too much risk. That’s how
diversification works. Something is always going to be underperforming.

For investors who turned to liquid alternatives to help broaden
their portfolio’s diversification after the financial crisis, it has
often been the part of the portfolio that’s been more disappointing
than not.

How we measured the performance of liquid alternatives

To really gauge a liquid alternative fund’s performance, investors
should go beyond looking at absolute returns. Liquid alternatives are
supposed to add an additional layer of diversification to a portfolio,
so it only makes sense to include them when evaluating a fund’s performance.

To see how liquid alternatives have fared over the last three and
five years, we ran a simple test to evaluate whether liquid
alternative funds would’ve improved the risk-adjusted returns of a
hypothetical, basic 60/40 portfolio of stocks and bonds.

This framework for evaluating alternative funds builds upon the
Morningstar Style BoxTM for alternative funds, which makes
it easier for investor to gauge a fund’s diversification
characteristics. The alternatives style box is available in Morningstar DirectSM.

For this study, we used a simple formula to tell if the alternative
fund could have potentially improved the portfolio, and if so, we used
an optimization process to find out by how much it could have improved
the portfolio’s risk-adjusted returns, measured by the Sharpe ratio.

For comparison’s sake, we also ran the test with some other
Morningstar Categories that are typically thought of as diversifying,
like tactical allocation or nontraditional bond funds. The two charts
below show the number of funds in each category that didn’t improve
the portfolio (i.e. an investor would've been better off not owning
them), that improved the portfolio’s Sharpe ratio by between 1% and
10% (these basically did no harm but didn’t offer much improvement
either), and those that improved the Sharpe ratio by more than 10%.

How liquid alternatives fared over the last 5 years

For illustrative purposes only.

How liquid alternatives fared over the last 3 years

For illustrative purposes only.

Most liquid alternatives have not made a positive impact

According to our research, most liquid alternative funds failed to
improve a traditional stock and bond portfolio over both time periods,
although market neutral funds had a decent showing over both time
periods and nontraditional bonds look particularly useful over the
more recent time frame.

Indeed, it’s been a difficult period for most diversifying
strategies, given the low volatility in equity markets as they've
continued to march higher. Despite a recent uptick in short-term
interest rates, it’s also been a largely favorable environment for
bonds. Of course, this doesn’t mean that liquid alternatives can’t
potentially help portfolios over the next three and five years. But so
far, they haven’t been as helpful as many investors probably expected.

The rolling 5-year results of adding hedge funds to the
traditional portfolio

Hedge funds haven’t fared much better recently either, which
indicates that it may not be a structural problem with liquid
alternatives that’s driving the poor results. One concern when hedge
fund strategies started migrating over to mutual funds at a lower cost
is that they would be watered down versions. That doesn’t appear to be
the case, at least not yet.

For illustrative purposes
only.

Liquid alternative funds appear to be falling

One of the side effects of the strong traditional portfolio
returns and the less-than-stellar results for many liquid
alternatives has been an acceleration of closings of liquid
alternative funds. This makes picking liquid alternatives even more
of a challenge for many investors.

The table below shows the
10 Morningstar Categories with the highest rate of obsolete funds
over the five years ended May 31, 2018. To find the percentage of
obsolete funds, we looked at total unique funds that existed over
the period in each category and the number of unique funds that were
liquidated or merged away over the period. We excluded categories
with less than 50 total unique funds during the period.

The four categories with the highest rate of
fund deaths over the five years fell under the liquid alternatives
umbrella. If an investor blindly bought a managed-futures,
multialternative, long-short equity, or market-neutral fund over the
past five years, there's about a 33% chance the fund no longer
exists.

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